Trading with the CRB
Adam Hamilton
Archives
March 19, 2005
In last week's essay I discussed the magnificent breakout of
the CRB Commodities Index back above 300 for the first time in
24 years. I also delved into the concept of the Relative
CRB as a trading tool for futures speculators gaming the
CRB directly.
As I was digesting all of the excellent feedback that folks graciously
sent in, a thesis that kept popping up was the idea of using
the CRB index as some kind of trading indicator for individual
commodities. For example, can we as speculators watch the
CRB itself for important technical clues as to when high-probability-for-success
trades exist in individual commodities like oil?
This idea really intrigues me as well so I thought I would take
a look at it this week. Comparative market analysis, using other
markets to help determine the probable direction of the primary
market being studied, can be very valuable. A great example is
using the short-term machinations of the dollar
and euro to help forecast probable near-term gold action.
While using the CRB as a technical indicator for trading individual
commodities is an interesting concept, unfortunately the odds
are stacked against it working due to the way the CRB index is
calculated. The CRB custodians go to great lengths to smooth
out volatility in the 17 individual commodities that currently
make up the index.
Individual commodities are arithmetically averaged across their
various futures contracts that expire in the coming six months.
After this operation is done for all 17 commodities, all 17 simple
average prices are then geometrically averaged. All
the individual simple average commodity prices are multiplied
and then the 17th root is taken, yielding a geometric average
across all components.
Finally this geometric average result obtained from the 17th
root is divided by a 1967 base-year average for commodities prices
and multiplied by 100. The end result of these dual averages
over time in individual commodities and across all commodities
is a stalwart index that is the most resistant to component volatility
out of any other major index that I have ever studied.
This heavy mathematical smoothing is why I was so excited last week to
see the CRB surge so dramatically from support to resistance
like a rocket. In just five weeks the venerable index has catapulted
from 281 to 322, a phenomenal and very out-of-character 15% gain!
Such a sharp spike would be notable in any broad index, but in
a geometrically averaged one it is truly extraordinary.
One or two commodities alone are not enough to move a geometric
index so rapidly. Coffee, cocoa, orange juice, cotton, wheat,
corn, soybeans, natural gas, heating oil, and crude oil all contributed
to this latest stupendous five-week rise in the CRB. This list
of surging commodities includes 10 of the CRB 17, more than enough
to push it higher. The metals, of course, are conspicuous in
their absence.
Due to the geometric weighting employed, if gold or silver had
fallen sharply in the past five weeks their declines would barely
even have dented the CRB surge. Any one component commodity,
moving in any direction, will have a minimal impact on the headline
CRB due to the dual averaging process. Thus, even before we embark
it is mathematically unlikely that the CRB will prove to be a
useful technical indicator for trading individual commodities.
Nevertheless, a lower probability of success does not mean that
specific financial research should not be undertaken. Sometimes
the numbers have a way of surprising and valuable insight can
spring from even the most ill-fated research project.
As I mentioned last week, oil, gold, and silver are the
big three commodities for investment and speculation, either
directly via futures and physical or indirectly by buying leveraged
producers of these key commodities. A few other commodities like
copper, platinum, and natural gas can be played indirectly by
buying stocks, but most of the CRB 17 are not really conducive
to stock investment.
Wheat production, for example, is highly fragmented with countless
millions of small farmers around the world raising it. Finding
a major leveraged wheat-producer stock, if they actually exist,
is vastly harder than finding a major copper producer. The metal
and energy commodities are much easier to invest in indirectly
since they have huge upfront capital costs that only big publicly-traded
corporations can afford. Most of the agricultural commodities
have low barriers to entry and are too fragmented for stock investment.
While futures traders can play all CRB commodities directly,
futures accounts are only a small fraction of total investment
accounts today. With big leverage and the ever-present risk of
losing more capital than you initially bet, futures trading is
not for everyone. In addition, the futures markets are far more
efficient than stocks since futures traders are usually professionals
who only concentrate on a handful of contracts.
Stocks, on the other hand, tend to be very inefficient
with endless streams of speculators, professional and amateur,
finding their attention diverted by thousands of stocks from
which to pick. In general, the greatest profit potential lies
in the least efficient market, in this case equities. Futures
are great if you put a decade or more into understanding this
unforgiving realm, but for general investors stocks are easier,
less risky (you can't lose more than your initial bet), and less
efficient (more undiscovered opportunities for large profits).
In order to gain an understanding of how major turning points
in oil, gold, and silver compared to the CRB, we overlaid three
identical CRB charts from last week with the individual commodity
data. The CRB is drawn in red in all these charts, slaved to
the left axis. If you would like a better look at the CRB alone
for reference without the individual commodity overlays, please
check out the second
chart from last week.
I focused on two specific areas to research the CRB-as-an-individual-commodity-indicator
thesis, offsets and individual commodity performance during the
CRB's major uplegs and corrections in this CRB bull to date.
The offsets, noted below in green, show how many days before
or after a major CRB interim reversal that the individual commodities
mirrored the great trading opportunity. In late 2001, for example,
crude oil had an offset of +18 trading days from the CRB's own
interim bottom. This means that oil bottomed 18 days after
the CRB. Positive offsets denote trading days after the CRB's
major turns while negative offsets note trading days before.
Individual commodity offsets are important as they show how likely
an individual commodity is to experience a major tradable interim
high or low close to those of the underlying CRB itself. The
closer the average offsets for an individual commodity happen
to be, the higher the probability that the CRB may be a useful
trading indicator for that particular commodity.
The second thing I looked at is individual commodity performance
relative to the CRB over the exact dates marking major CRB uplegs
and corrections. The CRB has had three major uplegs and two major
corrections so far bull to date. If the CRB is going to be a
useful individual commodity trading indicator, then the index's
own major moves ought to mark similarly profitable moves in the
individual commodities.
In these charts, under each major CRB upleg and correction four
numbers are noted. The first red one is the CRB's actual performance
in that particular major move. The second blue one is the individual
commodity's performance over the identical date range to the
CRB's major move. The third yellow number shows the individual
commodity's leverage relative to the CRB. For example, if the
CRB went up 10% but the commodity went up 20%, then it would
have 2.00x leverage.
The final white number notes the correlation coefficient between
the CRB and the individual commodities during each of the CRB's
major moves. Generally the higher the individual commodity and
the CRB are correlated on average the higher the probability
that the CRB may prove to be a useful technical indicator for
that particular commodity.
We'll analyze oil, gold, and silver relative to the CRB in the
order of their relative risk and potential returns. Oil is the
least risky of these three elite commodities with the lowest
expected returns. Silver is the most risky with the highest expected
returns. Gold lies somewhere in the middle. Generally the smaller
an individual commodity's market, the greater its potential volatility
and returns.
Over a secular timeframe, since
their respective bulls launched in late 2001, oil and the CRB
have had a high correlation of 0.918. This leads to an r-square
value suggesting that 84% of the daily moves in oil can be explained
by the CRB's behavior, or vice versa. When the CRB is in a bull
market, oil ought to be as well as the recent years have proven.
Interestingly, however, on the tactical trading scale the correlation
of oil and the CRB over the CRB's individual uplegs was far weaker
at an average of only 0.578. This means that only 33% of the
daily moves in oil in an average individual upleg or correction
are explainable by corresponding moves in the CRB. Thus, the
long-term oil correlation with the CRB is high but it rapidly
breaks down over shorter trading timespans.
The average absolute value of the oil interim reversal offsets
to the CRB interim reversals confirms the fact that oil and the
CRB don't tend to turn at exactly the same time. On average,
a major interim top or bottom in crude oil can be expected within
+/- 16 trading days of a major interim top or bottom in the CRB.
This offset is probably fine for long-term secular investors,
but it is pretty sloppy for short-term speculators looking to
ride trends for a year or less.
Another problem arises when the CRB's second major correction
in 2004 is considered. During this time the CRB retreated 7%,
a typical correction, but oil was relatively strong clawing up
13% over the exact same period of time. In addition the CRB's
current upleg, number three, has only witnessed an oil/CRB correlation
of 0.698 so far, not very impressive. Thus the CRB's relationship
to oil seems to be weakening as time marches on.
In light of these observations, I think investors interested
in holding for over a year can gain some insight into the general
probability of major interim crude oil bottoms by watching the
CRB technicals. If the CRB is near its technical support line,
then oil should be approaching its own support as well.
Short-term speculators, on the other hand, will probably not
be well served by a CRB indicator for oil that has a six-week
margin for error on major long and short signals as well as deteriorating
correlations as of late. Trading oil with the CRB appears to
be far less efficient than trading
oil based on oil technicals alone.
Oil theoretically contributes to 1/17th of the CRB's major moves,
but its topping and bottoming timing is not very precise when
viewed through the lens of the CRB. Is gold any better?
Out of all three elite commodities,
gold's correlation with the CRB is the highest by far at 0.959
bull to date. This suggests that over a secular timeframe 92%
of gold's daily moves can be explained by the CRB's daily machinations.
While this certainly sounds good from a strategic perspective,
once again during tactical trading timespans it is definitely
found wanting.
Looking at the average absolute offset between gold and the CRB
around major interim trend changes, the CRB does not correspond
well with major gold trading signals at all. At +/- 44 trading
days either way, the CRB can carve a major interim top or bottom
months away from the corresponding interim reversal in
gold. Even recently, in mid-2004, gold bottomed a whopping 53
trading days before the CRB's corresponding bottom.
Interestingly, in raw performance terms, gold's average leverage
to the CRB during its major uplegs and corrections was only 0.85x
that of the CRB. If you are a futures speculator trying to decide
whether to play the CRB directly or play gold, this is interesting
food for thought. Gold's returns may still prove to be higher
though if they are measured from gold's own major interim reversals
instead of the CRB's.
Gold's average correlation with the CRB during its major intermediate
moves only ran 0.815, for an r-square value of just 66%. Thus,
gold does not seem to mirror the CRB to any great degree in terms
of the timing of its intermediate tops and bottoms.
Much like oil, a CRB index near its major support can help announce
that the season is right for gold to bottom, but it really
can't offer a high-probability time with any real precision.
This is useful for investors wanting to buy and hold for a few
years or more, but not as valuable to short-term traders.
As a gold speculator, to me it doesn't look like the CRB has
high potential to be a subsidiary technical indicator for gold.
I would much rather use pure gold-based indicators as well as
look at gold relative to its competing
major currencies the dollar and euro. Just like it did for
oil the CRB tends to be generally high or generally low along
with gold, but specific tradable bottoms and tops in the CRB
just don't correspond closely enough with those of gold.
Our final chart this week takes
a look at silver relative to the CRB, which is already a problematic
comparison since the silver bull started in earnest about 18
months after the general
commodities bull. As such, silver's overall daily correlation
with the CRB bull to date is only 0.875, really fairly low as
far as indicators go. Only 77% of silver's daily price moves
may be explainable by the CRB action since 2001.
Silver's offsets away from major interim tops and bottoms in
the CRB are also all over the map, having an absolute-value average
of 54 days, the highest by far out of all three elite commodities.
Its average correlation between all the CRB's major uplegs and
corrections was only 0.748, again pretty low. Like oil and gold
silver has a decent general correlation with the commodities
bull, but the CRB doesn't seem to provide tradable cues on silver
specifically.
In light of this cursory analysis, it looks like the intriguing
prospect of building a technical indicator out of the CRB that
can give trading signals in major individual component commodities
does not have a high probability for success. The CRB does tend
to mirror general strong and weak seasons in oil, gold,
and silver fairly well, but the actual dates of major interim
trend changes are all over the map.
Due to its aggressive across-time simple average individual commodity
prices and across-commodities geometric averaging, the CRB is
simply not very responsive to any of its individual components.
On average, less than 6% of the CRB's behavior is contributed
by any individual commodity. Thus if oil or gold are soaring
but the grains and meats are not, the CRB will more accurately
reflect the lion's share of its components' trends rather than
the outliers.
While it is a bit disappointing that a technical trading indicator
for individual commodities derived from the CRB was not more
forthcoming, the design of the CRB is not a bad thing at all.
Its careful construction and heavy smoothing operations combine
to form a very unbiased view of the commodities bull in
general. The CRB will move higher only if the majority
of its components are moving higher as well. It simply can't
rise significantly mathematically if only one or two of the CRB
17 are thriving.
Thus if you usually traffic in the oil, gold, or silver worlds,
but you want to peek out of the melee to see how commodities
in general are doing, the CRB index is the perfect place to look.
It paints a beautiful and clear strategic picture of commodities
in general, and its volatility-choking construction ensures that
it is a fair representation of the majority of commodities rather
than only the hot ones at the moment.
At Zeal we have been actively trading this Great
Commodities Bull of the 00s as well as developing innovative
technical indicators since its earliest days. While the CRB doesn't
have much precision in calling tops and bottoms in individual
commodities, many of our other indicators certainly do. If you
would like to mirror our own actual trades in elite leveraged
oil, gold, and silver producers when the probabilities seem highly
in our favor, please
join us today.
The bottom line is the CRB index is a great strategic measuring
rod that is probably all but impossible to manipulate based on
its heavily-smoothed construction. It deftly proves that we are
running in a glorious broad-based commodities bull, not
just individual bulls in oil, gold, silver, or other market-darling
commodities.
But the CRB's very strategic nature makes it inappropriate for
the construction of a tactical trading indicator to precisely
time trades in its individual component commodities. All the
averaging and smoothing it does simply renders the influence
of any individual commodity too immaterial to matter.
Adam Hamilton, CPA
March 18, 2005
Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!
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