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Divergence Of Oil And Gas Prices Offers Golden Pair Trade Opportunity

Summary Natural gas has slumped 33% over the last six months, but crude oil has fallen further, by 53%. As a result , the oil-gas ratio has tumbled 40% to 15.5, in the 4th percentile over the last five years. Theoretically, as gas becomes relatively more expensive to oil, drilling should shift away from oil and even into gas, if prices remain competitive, resulting in a normalization of the ratio. A long USO, short UNG pair trade will capitalize on this ratio returning to historical levels without net exposure to the tenuous commodity sector as a whole. Should the ratio return to its five year average of 25, a long USO/short UNG trade will net approximately 23%. A leveraged long UWTI/short UGAZ trade will yield approximately 70%. Investing in natural gas has been a challenge over the last year. After spiking to multi-year highs last winter thanks to the coldest winter in the past 20 years, the price of the commodity has been decimated over the past six months due to a combination of a mild summer and autumn that suppressed demand and record production. At Friday’s closing price of $3.12/MMBTU, the commodity is down 32.5% since June 1, 2014. As hard as it’s been to be a bull in the natural gas space, crude oil traders have an ever rougher deal. Thanks to record-setting U.S. production and OPEC willing to play a dangerous game of chicken with U.S. producers, the normally less-volatile crude oil is down 52.5% during the same period. Figure 1 below compares oil and natural gas prices over the last six months. (click to enlarge) Figure 1: 6-Month Oil/Gas Price Change (Pricing Data Sources EIA: NYMEX Futures Prices & Natural Gas Futures ) Depending on what source you read, oil is bound for either a rapid bounce to $60/barrel or doomed to slog around at $40/barrel for the next year or two. Likewise, for every article dooming natural gas to $2.00/MMBTU for the foreseeable future, another is predicting a new polar vortex that will send price soaring back to $4.00/MMBTU. Admittedly, there is an abnormally large degree of uncertainty in both sectors. Instead of trying to predict price movements in either commodity, this article will discuss a strategy to capitalize on a divergence from the historical relationship between the price of natural gas and oil. While natural gas has had a poor six-month performance, it is crude oil that has really been taken to the cleaners. As a result, natural gas has become more expensive relative to crude oil. Figure 2 below shows the Crude Oil-to-Natural Gas ratio over the last six years dating back to 2008. (click to enlarge) Figure 2: Oil-To-Gas Ratio 2008-Present (Source as above) The first half of 2008 marked the end of the era of vertical well drilling. In 2009 and beyond, directional drilling and fracking technology made the cost of hydrocarbon production significantly cheaper. However, the technology disproportionately benefited natural gas drillers. The crude oil-to-natural gas ratio therefore ballooned from around 12 in 2008 to a peak of 50 in early 2012 as natural gas prices plummeted to briefly under $2.00/MMBTU and oil prices stabilized around $100/barrel. The ratio has generally oscillated between 20 and 30 thereafter. However, as oil prices have tanked much faster than natural gas over the last six months, the ratio has plummeted over 40% from 27 in mid-July 2014 to 15.5 as of Friday’s close. This represents the 25th percentile since 2008 and the 4th percentile since 2010-the rough start of the fracking era. Rather than betting on a recovery in either natural gas or oil prices, an alternative strategy is a pair trade that bets on the recovery of this ratio to the historical range. This entails taking a short position in a natural gas ETF such as the United States Natural Gas ETF (NYSEARCA: UNG ) and a long position in an oil ETF such as the United States Oil ETF (NYSEARCA: USO ) such that a recovery in the crude oil-to-natural gas ratio will result in a net profitable position. If natural gas slumps and oil rallies-resulting in a rapid recovery in the ratio-both positions profit. If both natural gas and oil rally, but oil rallies more-resulting in a slower recovery in the ratio-the profits from the long oil position will outweigh the losses from the natural gas short. Likewise, should both fall but natural gas fall faster, the opposite will be true-profits from the natural gas short will outweigh losses from the oil long. Of course, should natural gas outperform oil, the pair trade will be a losing one-and because there is a short position involved, the losses may be extensive. However, this will result in the crude oil-to-natural gas ratio falling towards 10 and deviating even further from the historical averages. Approximate returns of this trade going long USO and short UNG are shown below in Figure 3 based on crude oil-to-natural gas ratio. I say “approximate” because the exact profitability varies slightly depending the exact prices of the two commodities (i.e. Oil at $60 and Gas at $3 vs. Oil at $40 and Gas at $2, both for a ratio of 20). These calculations assume a price of crude at $60/barrel, which represents the median of current analyst estimates for a 6 month price target, and natural gas at the corresponding value to satisfy the given ratio. Of note, real world returns may actually be boosted compared to these projections. It is well-established that rollover losses from contango can decimate an ETF. This is something that has plagued natural gas ETFs given the frequency at which this commodity trades with a large contango. Oil traditionally trades at a much smaller contango. Thus “excess” profits in the UNG short due to contango not affiliated with organic price movements will likely outweigh much smaller “excess” losses in the USO long due to contango. (click to enlarge) Figure 3: Projected profitability of a Long USO/Short UNG Pair Trade depending on Oil/Gas Ratio Should the ratio bounce just 30% to 20, the trade will return 14%. Should the ratio return to its 5-year historical average of 25, the trade returns 23%. I am currently invested in this trade using a position size that comprises 15% of my portfolio. Should the ratio slump under 15, I will look to slowly add to my positions. These returns can be boosted by using leveraged ETFs. Figure 4 below shows the same curve using a long Velocity Shares 3x Crude Oil ETN (NYSEARCA: UWTI ) and short Velocity Shares 3x Natural Gas ETN (NYSEARCA: UGAZ ) pair trade. (click to enlarge) Figure 4: Projected profitability of a Long UWTI/Short UGAZ Pair Trade depending on Oil/Gas Ratio Using this trade, profits will be around 41% should the ratio recover to 20 and 70% should the ratio climb to 25. However, this trade is not without risk. The excess leverage boosts losses such that should the crude oil-to-natural gas ratio fall to 10, losses will comprise the entire position due to the ballooning value of the short UGAZ short position. Secondly, the leveraged ETFs are not designed to track their underlying commodities in the long term. These ETFs tend to underperform, particularly in a choppy trade environment. Thus, should it take the oil-to-gas ratio > 6 months to reach a target level, expect actual returns to be less than projected. Beyond simple technicals-oil is due for a bounce after a nearly linear 6-month decline-the fundamental rational behind this trade is simple. As natural gas becomes more expensive relative to crude oil, it becomes less and less profitable to drill for liquid hydrocarbons versus gaseous hydrocarbons and rigs are gradually shunted from oil-directed to gas-directed. This trend is already reflected in the Baker Hughes Rig count. Figure 5 below shows the % change in oil-directed and gas-directed rigs over the past 6-months. (click to enlarge) Figure 5: Baker Hughes Rig Count Change In Oil And Gas Rigs Over The Last Six Months (Source: Baker Hughes ) Natural Gas-directed rigs have fallen 4.9% to 310 as of last Friday while Crude Oil rigs have fallen by 11.0% to 1366, or by 170 oil rigs and 16 gas rigs. Should this trend continue, it is likely that the crude oil supply will gradually stabilize while natural gas supply is more likely to remain near record levels, increasing the odds that the oil-to-gas ratio normalizes to historical levels. Additional disclosure: The author is also short UNG as discussed in the article.

Does The Presidential Cycle Have A Significant Impact On Stock Market Performance?

Summary The third year of a presidential cycle has historically offered outsized returns. In this study, data for 1928 to 2014 were analyzed to evaluate the effect of the presidential cycle on S&P 500 performance. Given that we are currently in Obama’s third year (of his second term), should we be expecting significant gains ahead? Introduction In a previous article entitled ” The January Effect Revisited And A Call For The Use Of Elementary Statistics “, I made the case that assertions of outperformance should be supported by elementary statistics. In the case of the January effect, I analyzed monthly data from 1988 to 2014 to show that the standard deviation of monthly returns was actually very large compared to the average return for any given month, rendering most of the observed seasonal deviations to be statistically insignificant. Yet, the absence of error bars on the most popular graphs illustrating the January effect means that investors studying the chart would be unable to ascertain whether [i] the outperformance is statistically significant and [ii] whether or not the increased return is worth the risk. The article ended with an exhortation for all analysts to incorporate simple statistical analysis into their charts. In the present article, we analyze another phenomenon that may be playing out at the present time: the impact of the presidential cycle (also known as the election cycle) on stock market performance. The following charts are top hits in a Google search for “presidential cycle stock market”. (Source: GoBankingRates ) (Source: Murray Financial Group ) (Source: Seeking Alpha ) (Source: John Rothe ) All four charts show the 3rd year of a president’s term to be the best in terms of stock market performance, and the 2nd year to be the worst. Interestingly, the last chart seems to show that the final quarter of the 2nd year actually delivers the best performance out of all 16 quarters in the presidential cycle. Now, what are all four charts missing? If you had read the previous article (or the introduction) you would know that the answer is “error bars”. Given that we are currently in the 3rd, and presumably “best”, year of Obama’s presidency (the second term), I was interested to determine whether or not the presidential cycle has a statistically significant impact on stock market performance. Results and discussion Yearly total return performance for S&P 500 (NYSEARCA: SPY ) from 1928 to 2014 was obtained from Aswath Damodaran . For the purposes of this study, the four-year presidential cycle is assumed to occur continuously even though there have been interruptions with certain presidents. For example, Gerald Ford’s first year in the office in 1974 would still be counted as the second year of the presidential cycle (since it would have been Richard Nixon’s 6th year in office). The S&P 500 annual total return distribution from 1928 to 2014 shows a bell-like shaped curve with a negative skew, from which the dreaded “left tail” can be observed. Yet, it should be noted that 63 out of the 87 years (or 72.4%) in this study have had positive returns. The average return over the 87 years was 11.53%, while the median return was 14.22%. This is one reason why “buy-and-hold” has worked so well for the average investor in the U.S. market. First let’s have a look at the average performance of the stock market over the four-year presidential cycle. (click to enlarge) Consistent with the charts presented in the introduction, we find that the 3rd year of the presidential cycle provides the greatest performance, with an average performance of 17.57% (and median of 22.34%). Moreover, the 3rd year was the only year that outperformed the average overall return of 11.53% (and median of 14.22%). The other three years all underperformed the average, with the 2nd year having the lowest return of 8.80% (and median of 10.00%), again consistent with previous charts. The next chart shows the data for average returns but with the inclusion of error bars representing the standard deviation of the results. (click to enlarge) We see that the standard deviation of the annual returns is larger than the actual returns (though not overwhelmingly so), indicating significant variability in the results. One way to visualize these error bars is to assume that about 68% (or just over two-thirds) of the data points lie between the error bars. A t-test was conducted to investigate whether or not the annual returns of each year of the presidential cycle is significantly different from the overall average return of 11.53%. The results are shown in the table below. 1st 2nd 3rd 4th Mean 8.99% 8.80% 17.57% 11.03% Standard deviation 22.01% 21.21% 18.90% 17.20% p-value 0.594 0.553 0.158 0.893 Significant? No No No No The results of the t-test show that none of the years of the presidential cycle are significantly different from the average year. A number of commenters in the previous article mentioned that because the return distribution is not exactly normal (there is some skewness or kurtosis), an alternative test such as the Wilcoxon test should be performed. Therefore, I also calculated the p-value using the one-sample Wilcoxon signed-rank test to determine whether the median returns for each year of the presidential cycle was significantly different from the overall median return of 14.22%. 1st 2nd 3rd 4th Median 7.40% 10.00% 22.34% 13.35% p-value p> 0.10 p> 0.10 p> 0.10 p> 0.10 Significant? No No No No Similarly, the one-sample Wilcoxon signed-ranked test shows that none of the observed performances were significant. (It is noted that the Wilcoxon test assumes a symmetrical distribution, which is not perfectly valid for the present distribution. I considered the one-sample sign test, but that test does not capture the magnitude of differences from the median. If anyone knows another simple one-sample, non-normal, non-symmetric test that can be used instead, please let me and the readers know!) C onclusion While the 3rd year of a presidential term has delivered, on average, outsized returns for the past 87 years (from 1928 to 2014), any deviations between any of the years of the presidential cycle and the average or median return were found to be insignificant. Note that statistical tests such as these do not “disprove” the presidential cycle effect, nor do they prevent you from profiting (or attempting to profit) from the perceived opportunity. What the tests do tell you is that for the past 87 years, any impact that the presidential cycle has had on stock market returns is indistinguishable from chance. Therefore, this article ends with another call for analysts to incorporate simple statistical analysis into their presentations. This information would allow investors to evaluate [i] whether the outperformance is statistically significant and [ii] whether or not the increased return is worth the risk. Author’s note: On a personal level, I was rather disappointed in the outcome of this study. Given that we are currently in the 3rd year of the presidential cycle, I was really hoping that the effect would be significant. I guess that’s confirmation bias creeping in!

3 Promising India Focused ETFs

Summary India will overtake China’s GDP growth rate in 201 according to IMF and I believe that Indian equities are positioned for a multi-year bull market. Infrastructure is India’s biggest challenge as well as the biggest opportunity and I believe that the sector will perform well amidst lower interest rates in the foreseeable future. India’s consumption story has just commenced and with very favorable demographics, India’s consumption is likely to grow at a robust pace making the consumer related ETF attractive. While the focus has been on large companies in the recent rally in Indian markets, the small companies hold immense long-term potential and the small-cap ETF looks attractive. India is poised to overtake China’s GDP growth in 2016 according to the IMF and I have been bullish on India since the new government came to power in 2014. Recently, I wrote an article on IMFs GDP outlook for 2015 and 2016 where I opined that India and the US are the bright spots in the global economy and I also opined that India is likely to be the best performing equity market in 2015. I had also provided two stock picks and one ETF for exposure to Indian markets. In this article, I will be discussing three more ETFs that look very interesting considering a 2-3 year time horizon. I believe that these ETFs can serve as catalyst for the portfolio and investors need to diversify to India in order to boost overall portfolio returns. EG Shares India Infrastructure ETF (NYSEARCA: INXX ) The India Infrastructure ETF is designed to measure the market performance of companies in the infrastructure industry in India. For 2014, the ETF provided returns of 20% and I believe that the ETF will provide returns in excess of 20% in 2015. The reasons are as follows – The Indian central bank cut interest rates by 25 basis points recently and another 75-100 basis points interest rate cut is likely. Lower interest rates will trigger upside for the interest rate sensitive infrastructure sector. As the chart below shows, India needs infrastructure investment of nearly $1.25 trillion over the next 10-years and as the pace of investment grows under the new government, infrastructure companies are likely to outperform. (click to enlarge) The ETF has high exposure to large and very large infrastructure companies in India and therefore the exposure is with companies having strong fundamentals. The trailing PE ratio of the ETF holdings is 17.9, which is lower than the broader NIFTY PE of 22.2. Therefore, on a relative basis, the sector is still undervalued and has upside potential. For these strong reasons, the EG Shares India Infrastructure ETF is an interesting ETF to consider not only for 2015, but with a long-term investment horizon. EGShares India Consumer ETF (NYSEARCA: INCO ) As the name suggests, the India Consumer ETF is focused on the consumption theme. For 2014, the ETF provided an extraordinary return of 48%. While the same performance might not be replicated in 2015, the fund still looks very promising for strong returns over the next 3-5 years and a return of 15% to 20% in 2015 on a conservative basis. The Indian consumption theme has just commenced and Amazon (NASDAQ: AMZN ) clocking gross sales of $1 billion in the first year of operation in India is an indication of the potential the broad consumption theme holds in India. The PwC report is also upbeat on the media and entertainment sector in India for the next 5 years. Further, India is set to become the youngest country in the world by 2020 and the favourable demographics mean that India has huge potential when it come to consumption themes such as personal goods, automobiles, media and entertainment. The India Consumer ETF provides exposure to all these sectors of the economy with exposure to all the big players in the respective industries. I therefore expect the ETF to provide stellar returns considering a time horizon of 3-5 years. India Small-Cap Index ETF (NYSEARCA: SCIF ) I believe that the Indian Small-Cap Index ETF, which has provided returns of 43% in the last one year, is another excellent ETF to consider for 2015 as well as for the next 3-5 years. The above mentioned ETFs would give investors exposure to large or very large companies in India in the respective sectors. However, there is immense potential in some of the small or mid-sized companies in India. The growth for these companies can be robust if overall economic growth and sector growth is strong. With the ETF currently having 30.1% exposure to the financial sector, 21.1% exposure to the consumer discretionary sector and 17.6% exposure to the industrials sector, the outlook for the ETF will certainly be robust in 2015. In particular, the financial sector will surge on low inflation and rate cuts and both these factors will also impact the consumer discretionary and industrials sector. As of December 2014, the ETF had a very low PE of 11.24 and I believe that the ETF has strong upside in the coming quarters. In general, the broad market rally is led by large-caps followed by mid-caps and small-caps. Therefore, I expect the ETF to start moving significantly higher based on current valuations. Conclusion India is certainly one of the most attractive markets for 2015 and I believe that the Indian economy is on a path to sustained and robust growth in the next 5-10 years. Therefore, investors need to have Indian stocks in their portfolio and the ETFs discussed have the potential of providing 15% to 30% annual returns if the government keeps its promise on drastic policy changes in the coming months.