Central Banking and the Destruction of Free Markets

Submitted by Jeffrey Snider of Atlantic Capital Management
Volatility Is The Price Of Real Progress
As we all ponder what may come at us in 2012, the ongoing volatility in almost every corner of every marketplace is certainly concerning, as it should be.  This record volatility has enormous implications for any investor, but especially those in leveraged ETF’s.  Volatility is the anathema to these vehicles, as has been well discussed, but that does not diminish their targeted usefulness.
As a portfolio manager I use leveraged inverse ETF’s as hedges against the dramatic downside.  They have a very narrow window and only perform when the market more or less moves in a straight-line down – just as it did in early October 2008, May 2010 or July/August 2011.  Other than those sustained sell-offs, they are a drag on portfolio performance, a cost of doing business in this risk-on, risk-off “marketplace”. 
I willingly pay that cost because I have no concrete idea when another fit of sustained selling will actually take place, but I have more than an inkling that it will.  Instead, this massive and growing volatility, even though it is costing me some short-term performance, is a good sign that there is actually progress being made.  What we are witnessing is a titanic battle between the world as it really is and the one central banks need you to believe it might be (if only you would set aside your own perceptions and self-interest).  The fact that volatility has risen is a clear indication that the central bank-inspired anesthesia is no longer as effective as it was in 2009, or even in the QE 2.0 inspired insanity of 2010.  Reality, and the free market, is being imposed – and that means there is a place for even narrowly-useful hedging vehicles.
The current market battle is nothing more than the extreme measures of the rational expectations theory and a form of the fallacy of composition, combined with the political aspirations of a century-old theoretical notion of how the economic system should be ordered.  Mainstream economic “science” has developed in a relatively straight line since the Great Depression, starting with the idea that the economy must be governed in emergencies.  Executive Order 6102 and the subsequent devaluation of the dollar solidified the place for the entire field of economic management, marking perhaps the last time it would be challenged by mainstream thought.
Without the guiding hand of the educated economist, capitalist, free market economies are believed to be wrought with the danger of total collapse, unable to escape from their own emotional whimsies.  At the most primal level of modern economics is a deathly fear of deflation, a fear that is best summed up by Fisher’s paradox.
In 1933, Irving Fisher published a paper in the Federal Reserve’s Econometrica circular that amounted to a point-by-point logical deduction of the string of events that led to the unusual collapse of the economic and banking systems.  The scale and pace of the disaster confounded “experts” of the era (it seems experts have trouble with inflections in every era), so his deduction offered a highly plausible, well-reasoned and “logical” explanation. 
For Fisher, the combination of over-indebtedness and deflation was the toxic mix from which the calamity grew.  But within that mix lay a paradox that formed a trap by which no self-made recovery was possible:

“…if the over-indebtedness with which we started was great enough, the liquidations of debts cannot keep up with the fall of prices which it causes.  In that case, the liquidation defeats itself.  While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed.  Then, the very effort of individuals to less their burden increases it, because the mass effect of the stampede to liquidate in swelling each dollar owed.  Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions:  the more the debtors pay, the more they owe.  The more the economic boat tips, the more it tends to tip.  It is not tending to right itself, but is capsizing.”

The lessons of this paradox are interwoven into the fabric of modern/conventional economics, that whenever deflation might be present a recovery has to be forced since it cannot start on its own.  But it is extremely curious that only one half of the equation was chosen as an outcast:  deflation.  Over-indebtedness has, obviously, been warmly embraced in the decades since Fisher’s proposition.  The development of the mainstream of economics has led to the belief that intentional inflation can always defeat deflation, and therefore debt can assume a role, even a primary role, within the schematic of economic stewardship.
Fisher’s paradox survives in many forms, but among the most important was a logical derivation, namely the idea that economic participants can do what they believe is best for themselves, but in doing so harm themselves through systemic processes.  This is known as a fallacy of composition; that what is good for individuals is not necessarily best for the whole.  It overturned the traditional economic notion of an economy at its most basic level, from the time of Adam Smith describing individual self-fulfillment.  Sure, this idea had been around for awhile before Fisher’s paper, but the Great Depression “proved” that the fallacy was real and potentially cataclysmic.  Originally it was confined to the narrow interpretation of depression economics, and so the evolution of unquestioned economic management started from there.
The economics profession truly believes that there exists economic states where individual self-maximization no longer benefits the larger societal association of economic actions, so it “logically” follows that some process (or entity) has to step in and enforce conditions contrary to individual notions of self-maximization.  In other words, there are times when people must be forced to do what they perceive is against their own best interest.
In the context of depression avoidance this seems to be rather innocuous, but in the displacement of political thinking since the 1930’s, it was a slippery slope.  What Fisher’s paradox essentially required was a benevolent authority to administer and visit a kind of beneficial tyranny upon the economic population.  In the constant forward roll of history, though, the slippery slope of needed benevolence has been applied to a larger and larger cohort of economic circumstances – emergencies breed human desire for such authoritarianism.
It is important to remember that the Federal Reserve was a secondary institution for much of the post-Depression period.  After the monetary debacles of the Great Depression, especially the unnecessary reserve requirement hike in 1936 that initiated the depression-within-a-depression in 1937, the Fed was relegated to being simply a monetary check-writer.  The Treasury Dept. was the economic powerhouse, especially during a time in which the dollar was the primary tool of economic management.  The Fed was consigned to managing the money supply around treasury debt auctions to ensure the federal government’s uninterrupted ability to borrow (in some ways things never change).  When that borrowing exploded in 1965, the money supply went with it and the seeds of the Great Inflation were embedded.
Paul Volcker changed this with his “heroism” in defense of the dollar, a dramatic departure from the previous era of Treasury Dept. domination.  Conventional wisdom posits that it was Volcker’s Fed that vanquished the inflation dragon, in doing so he “created” another pillar of the fallacy of composition (high interest rates were not good for individuals, but seemed to be good for the larger system).  The chastened Fed of 1965 that allowed inflation to begin building was dropped for the activist Fed of 1980 that could apparently do no wrong (the monetary history of the 1970’s was completely and conveniently ignored).  The Fed’s reputation soared with the perceived economic success of the 1980’s, handing Alan Greenspan an amount of power unparalleled in human history. 
But how much economic success in the 1980’s was earned?  Again, conventional wisdom sees the Great Inflation ending in 1982, giving way to the Golden Age of Economic kingship – the Great Moderation.  What I see is simply a transformation of inflation from consumer prices to asset prices.  Instead of overwrought money creation circulating within the real economy in the form of wages and higher consumer prices, new credit production capabilities allowed a secondary circulation of credit money into assets, indirectly feeding into the real economy – first as interest income, second as debt – as the notorious “wealth effect”.  The economy in this age would transform from one based on earned income to one based on paper movements of created money, with the irony of the “wealth effect” being its tendency to incrementally create economic activity without actually creating productive wealth.  The global economy was increasingly reliant solely on money creation, a transformation that cannot be understated and a prime cause for re-evaluating the whole of the Great Moderation.
We see this quite clearly in the consumerism of the period.  In 1975, household spending was still largely a function of wage income.  If we adjust Disposable Personal Income by subtracting asset income (interest and dividends), we see a modest deficit in spending sources of about 3.5%.  Households spent more than they brought in from wages, benefits, government transfers (net of taxes) and rental income. Consumer/household spending needed asset income to make up that small funding shortfall (and to go beyond to generate a positive savings rate).  By the midpoint of the Great “Moderation” in 1990, the spending deficit was a chasm, 19.3%.  Without the $898 billion (nominal dollars) in asset income there was no way that consumer spending would have grown so far so fast.
That interest/asset income was a leftover effect of the Great Inflation when monetary creation found its way into growing stockpiles of “safe” financial assets for the household sector.  By 1990, US households had accumulated $5.1 trillion in deposits and credit market assets (largely US treasury bonds) against only $3.6 trillion in debt (including mortgages).  But that was a huge “problem” for the growing acumen of an activist Federal Reserve.  As the 1980’s progressed, interest rates were declining with consumer inflation (and providing a helping hand to asset prices running wild with credit now focused in that direction).  The mainstream of economics took this as a sign of success, but it was really just a marked decrease in monetary efficiency since new money was now circulating heavily in asset prices (the junk bond bubble and the new, great bull market in equities).
Concurrently, economic management had evolved in the 1980’s with the innovation of the “rational expectations” theory.  It was hailed as a huge advancement in monetary thinking coming out of the Great Inflation.  In many ways it was an adjunct to the fallacy of composition.  The rational expectations theory holds that the economic children of modern society can be fooled into undertaking activity that might be against their own best interest if some benevolent authority simply makes it look like everything will be better in the not-too-distant future.  If the Fed screws with the price and cost of money (for debt accumulation), manipulates the price of gold (for inflation expectations), or “nudges” stock or real estate prices in the “right” direction (the notorious wealth effect), the population will act today on those conjured expectations of good times tomorrow.
By the end of the 1980’s, the S&L crisis (a stark warning that economic management might not have been all that it was advertised to be, a warning that has largely been ignored) threatened to plunge the world back into depression.  The Fed and Alan Greenspan feared the consequences of a banking crisis and any attendant deflation.  The Fed funds rate was pushed from around 8.25% in April 1990 to a ridiculous 3.25% by July 1992 – staying at that low level well into 1994.  Alan Greenspan was trying to save the entire banking system from the S&L crisis by reducing the cost of funds so dramatically (hoping to see an increase in bank profits, leading to higher retained earnings and therefore equity capital upon which to pyramid more debt).  The pressure on household spending because of the collapse in interest rates necessitated a marginal change in spending, but not back toward earned income.  Instead we got the wealth effect and the myth of Greenspan’s genius.
Despite a persistently weak recovery (just ask George HW Bush) from a relatively mild recession, the Fed’s management of the economy into a “soft landing” was hailed as a new form of a New World Order.  The business cycle could be smoothed (or even eliminated) by the marginal attraction to debt and the wealth effect.  If expectations were properly managed, the public would suppress their base emotional instincts and dance to the tune set by the monetary kingship. 
It was hubris of the highest order, of course.  By the time the tech bubble finally burst (another warning of the dangers of an artificial economy) the Fed doubled down to save itself and its primacy.  The results have been disastrous as the marginal economy progressed further and further away from the fundamental foundation of wages and earned income.  The savings rate fell to zero by 2005.  Worse than that, US households added $10 TRILLION (+269%) in debt between 1990 and 2007, with $7 TRILLION coming after 2002 alone.  The household funding deficit reached a high of 24%!  Even worse than that, households had shifted preferences out of “safe” credit market assets or bank deposits and into much riskier price assets simply because the systemic cost of risk was intentionally held artificially low.
The economic foundation of the Great Moderation was an illusion, nothing more than asset prices and debt; wealth effect and rational expectations.  None of this describes a free market, capitalist economy.
Central banks and economists love to talk about economic potential, spending so much time trying to calculate it with their complex modeling capabilities and elegant mathematical equations.  But the hard truth of economic overlordship is rather simple.  The Federal Reserve, in cooperation with global central banks, Wall Street and the interbank wholesale money marketplace, simply substituted credit for earned income.  And the reason is also very simple, because debt accumulation is far more easily manipulated.  As long as households remained attached to earned income and “safe” savings assets, economic management was nearly impossible.  The rational expectations theory needs a system more attuned by asset prices and malleable debt levels.  And so marginal consumer spending shifted away from the solid foundation of jobs and wages right into the hands of the fallacy of composition and the rational expectations theory.
It is more than a little ironic that the Fed so willingly embraced indebtedness in light of their history with Fisher’s paradox.  But mathematical advances in modeling along with a growing commitment to steady inflation allowed the Fed to really believe it could stave off deflation.  So they made a deal with the debt devil to obtain the keys to the marginal economic castle and its grand artificial economy, and in the process dangerously surrendered to the over-indebted part of the Fisher’s paradox equation.  Thus the housing bubble to mediate the tech bubble since the tech bubble had some potentially deflationary consequences.  Even today, everything the Fed has done since 2007 can be seen in these terms:  the fallacy of composition, rational expectations and the preservation of the benevolent stewardship of the economic, academic masters. 
Somewhere in all this transition from Fisher’s paradox to Greenspan’s genius to debt-slavery, the system ceased to function as a free-market, capitalist system.  The free market values the bottom-up dispersal and divergence of billions and billions of free opinions, freely associating together as unfettered price discovery.  A central bank devoted to the fallacy of composition and rational expectations is a top-down system committed to manipulating price discovery to achieve ends that seem to be, and very often are, contrary to the perceptions of the vast majority of doltish economic participants.  The monetarist system is forced upon the population, no matter how much they resist. 
Indeed, the idea of an economic fallacy of composition is itself a logical fallacy.  I have no quarrel with the idea of a fallacy of composition or any logical fallacy for that matter, but logic holds no special place in social interactions.  There are no logical deductions from economics no matter how much math is applied.  It is, and will remain, a subjective interpretation of events.  Even the vaunted Fed and its accumulation of Ivy League PhD’s performs no leaps of logic.  Like anyone else with an opinion, whatever fallacy of composition it thinks it sees is still just subjective interpretation. 
And that is the real danger.  Cloaked in the apparent objectivity of math, the economic elite have gained unlimited economic power.  When you stop and think about it, you can create a fallacy of composition pretty much anywhere (and write and enforce rules based on it) – from the steep tax on savers with five-plus years of zero interest rates to mandating everyone has to purchase health insurance even if they don’t have the need for it.
The volatility of today is nothing more than a fight between the active perceptions of participants trying to maximize self-interest within the classical, traditional concept of a free economy, and the opposing forces of overlordship of the landed economic elite, trying to get the uninitiated to simply follow orders.  The elite really believes that if everyone would gladly pile on even more debt and spend with reckless abandon, the Great Moderation would once again be within reach.  Consumers should only stop thinking for and of themselves since common sense is dangerous to the controlled economic system.  To get more debt “flowing” requires active price manipulation to make the world seem like it will be better in the near future so that people will start acting like it.
Economic potential to the Fed is the level of economic activity of 2006.  To them, this is a cyclical recovery from a cyclical interruption in their normal smoothing of the business cycle.  Sure it veered way off into panic, but that was just more confirmation that human emotion needs to be managed.  But if we view the economy from the historical perspective, the lack of a cyclical recovery is not at all surprising.  The Fed spent decades building up so much monetary inefficiency, so many artificial monetary channels for indirectly “stimulating” economic activity, that it will simply take an enormous amount of new money to get it all moving in the “right” direction again (Ben Bernanke and Paul Krugman at least have that part right). 
The fact that resistance is growing, that investors are not drinking the economic Kool-Aid as much as 2009 or late 2010 is a sign of growing discord.  The efforts in the realm of rational expectations are simply not working.  That is the ultimate danger because the entire central bank gameplan is based on only that.  Without willing adherents (useful idiots?) to the central authority of economic management, everything falls back to the true potential – earned income and boring cash flow of un-manipulated dollars or euros.  With such a massive chasm between marginal economic activity and earned income sources of spending, it is not likely to be a shallow or short transition (this explains most of the inability of the economy to create jobs – so many jobs in the central planning era were based on money creation and financial “innovation”).
That is both the opportunity and danger of a system reaching its logical end.  Put another way, there is a growing realization that while free markets are messy and somewhat unstable, central planning is not really a cure for those symptoms.  In fact, it has created more harm ($13 trillion in debt is only US households) than good, more illusion than solid results.  Volatility means that the free market is at least attempting to impose itself at the expense of central planning’s soft financial repression and control.  By no means is such a beneficial outcome assured; rather the other half of all this volatility (the risk-on days) is the status quo desperately trying to hang on through any and all means (even those less than legal, like bailing out Europe through cheapened dollar swaps).
So the cost of using leveraged ETF’s as insurance against the failure of soft central planning necessarily rises, but that just may mean their ultimate usefulness is closer to being realized.  Unless you know exactly when this transition might reach its conclusion, it is, in my opinion, a cost worth bearing.

ETFs Vs. Futures

by Jeff Carter:

In the comments, and in my email I received corrections on my math.  That 500 SPY equal 1 ES.  That changes the calculation on my profit/loss.   Also in calculating the emini profit, I made the mistake of calling a 5 lot emini trade a “one lot” trade.  My confusion came from 5 ES=1 SP.
The advantages of futures are these:
1.  lower commissions
2.  little or no slippage, no trading against your order, no internalization of your order.
3.  more bang for the buck, you are able to control a lot of stock for smaller money.
4.  ability to trade 24/7
5.  Faster electronic systems. Futures platforms are speedier for the retail trader.
6.  Better taxation
ETF advantages
1.  Less volatility; the market isn’t as highly leveraged
2.  More accessible through more retail platforms.  Your broker might not offer futures.
3.  If you decide to step up your size, your commission rate can go down.  In futures to get rates down you must lease or purchase a seat at a futures exchange.
Original Post with corrections below (corrections in italics)
There are a lot of fund manager’s that recommend ETF’s. There are a lot of traders that like trading them, and the retail public seems to like them. ETF’s can be pretty innovative. They allow you to take a flyer on a market segment, while still incorporating Eugene Fama’s efficient market hypothesis(EMH) because you aren’t picking a single stock, but a basket of them.
If you adhere to the EMH, you will be invested in a mutual fund or ETF that replicates that broader market. Buying sector ETF’s allow you to raise the “beta” in your portfolio, assume a little more risk, without assuming the risk of holding one single stock.
However, if you are looking to increase your beta on the entire market, you’d be better off trading futures. If you want to cash in on the commodities craze don’t trade a commodities ETF.  You’ll be better off in the futures market.
Let’s compare and contrast a popular futures contracts with it’s ETF. Everyone knows about the S+P 500. It is the fund manager’s index. The ETF that replicates that index is called the $SPY or “spider”. The futures contract that replicates it is the S+P 500, but there is a bite sized contract called the emini S+P that is exclusively traded electronically.
For this example, assume that you thought the market was going up. We will also assume you are clairvoyant, and bought the low of the day and sold the high of the day.
If you buy a $SPY, the commission rate for a normal trader is $9.99. Some discount houses don’t charge you a commission at all! Of course, that means they are trading in house against your order and giving you a worse price than you would have gotten in the market. Or, they are selling your order to a hedge fund or bank and you still are getting a worse price. Let’s assume your slippage is only one penny, it’s probably a bit more.  There is no free lunch anywhere in the market.  If you are buying 1000 contracts though, it’s still costing you an extra $10 on each side of your trade, or $20 all day.
Yesterday’s $SPY range (2/4/2011) was 130.23-131.20, or .97. If you bought the low and sold the high you made $970. Nice trade! Of course, your commission costs were $19.98, slippage costs $20, leaving you with a profit of $930.02. Uncle Sam wants his piece. That will cost you 35% in the top tax bracket. $325.51 bucks. Your net/net is $604.51. You can still buy the first round of beers at the close.
But, what if you did the same thing in the futures market using an eMini S+P? The cost to trade 1 eMini future is $2.01.  To compare apples to apples, you would have executed a two lot.   2 ES=500 SPY Commission=$4.02. In futures, there is no internalization or payment for order flow.  You play in the same pool with everyone else.  Advantage here is the futures market by $35.97 all in on commissions and slippage.
The range yesterday was 1298-1308.50 If you bought the low, and sold the high you made 10.50. On a  2 lot trade, you made $525.  Less commissions, you made $520.98.  Uncle Sam still wants his piece, but he wants it in a different manner.  Futures are taxed at 60/40.  This means 60% of your gain is taxed at the capital gains rate, 15%, and 40% at whatever the highest tax bracket rate is.  In this case, the highest rate is 35%.  The blended rate works out to be roughly 23% or $119.83.  Your net profit is $401.15.
ETF profit, 604.51.  ES profit $401.15.   $203.36 in favor of the ETF. For every future you add, you get $262.50 added to your profit.   It costs you $2.01 to add.  If you trade 3 futures, the profit is equivalent.
Already I can hear the critics and retail brokers screaming.
Here are some other differences in the markets.  Futures trade 24 hours, and are more volatile than ETF’s.  I’d readily concede that point. Because futures are traded on margin, they have more volatility.  ETF’s margin can only be 50%.  A futures contract will always have more intraday volatility than a cash equity contract.
They will say the ranges of the two products are different, so of course the money will be different.  However, dollar for dollar the all in costs of trading+taxes are significantly higher in the ETF world than the futures world.  Let’s assume I made $1000 bucks in each.  After commissions, slippage and taxes, my take in the ETF would be $624.01.  In futures, $754.52.  You are giving up 21% of your profits for the same analysis that goes into the trade!
You might say, I don’t trade 1000 lots in the stock market.  That’s cool.  You can assume as much or as little risk as you want in the futures trading.  Just remember 1 eMini~ 250 500 shares.  As you trade less, the advantage swings to futures even more, because commission rates get even cheaper by comparison.
The bang for the buck you get with futures, lower all in commissions, and lower taxes gives you incentive to take on that volatility.  Plus, virtually all futures are traded electronically.  You are not waiting to find out if you are filled.  You are filled in the blink of an eye.
The nice thing about ETF’s is that there are so many of them.  They are pretty versatile so you can use different ones to try and take on more risk.  The federal government via the SEC prohibits trading of narrow based indexes.  Exchanges like CME Group and ICE can’t offer a futures contract based on a narrow basket of stocks.  There are ETF’s that you may want to trade that cannot be replicated by futures.
But, if you are going to trade Gold ETF’s you can see from the above example you’d be far better off trading Gold eMini’s.  If you want to trade an Oil ETF, you are far better off trading an Oil eMini.  Take a flyer on a currency?  You are better off trading eMicro’s or eMini currencies at $CME.
You get the picture.  Expand your horizons and you will expand your profitability.

Forbes Making the Case for Commodities

from Forbes mag:

It's been a frustrating and volatile year for stock market investors. Just when we thought we were out of the woods after the financial market crisis, trouble in the eurozone reintroduced the possibility of a global double-dip recession. Both the Dow Jones Industrial Average and the Standard & Poor's 500 fell into the red this summer. U.S. Treasuries and cash may be safe, but where do you find return?
Gold has historically served as a safe haven in times of economic distress and has performed extraordinarily well over the past decade. Gold prices have risen for nine straight years, including a 24% gain in 2009. This May the metal reached a nominal record high north of $1,200 per ounce. All told. gold is up 8% so far this year.
Investors can access gold by buying coins or bullion, gold exchange-traded funds, like SPDR Gold Shares and iShares Comex Gold Trust, or gold futures contracts. There are pros and cons to each, which include pricing, risk and taxes.
In Pictures: Seven Ways To Invest In Gold
While investors are familiar with gold, they may be missing an opportunity to participate in markets that offer similar diversification, including grains and energies. As with any asset class, investing in these commodities requires considering a number of issues and risk factors. Following are some of the most important ones.
Timing: In 1999, when the stock market was booming, commodities were a hard sell. Gold was trading below $300 an ounce. Crude oil was trading under $20 a barrel. Over the course of the following decade, gold rose 278% and crude oil 183%. Compare that with the "lost" decade for stocks.
One thing stocks and commodities have in common is that investors tend to buy them when they probably should be most cautious--when prices are near record highs. On the flipside, few investors were interested in buying crude oil contracts in 2009. Instead of going along with the crowd, however, ask yourself: What markets are over- or under-valued based on historical standards? And, how can I take advantage of that?
Pricing: When you buy or sell gold coins or jewelry, the price you pay or receive doesn't mirror the futures price due to the influence of retail demand and mark-ups. A coin or piece of jewelry is altered rather than a pure play on the commodity.
That's why many investors turn to ETFs or individual sector stocks to gain exposure to gold and other commodities, which are impractical to store and hold. Even when you invest in commodity-based stocks or ETFs, however, you aren't getting a perfect correlation to the price of the actual commodity. In fact, returns may vary significantly.

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Investors who choose commodity futures get the purest play and are not subject to company-specific issues as they are when owning stocks or ETFs. Futures also enable investors to take positions on either side of the market and profit from a price decline as well as from a gain. If you feel the price of gold is going up, you can buy a gold futures contract (go long). If you feel it's going down, you can sell a contract (go short). Returns are not dependent on market direction, and unlike with ETFs and stocks, electronic futures markets are open nearly 24 hours a day.
Risk: The biggest risk with a stock or ETF is that it will become worthless and you'll lose your entire investment. Commodity futures, by contrast, are backed by tangible value that is unlikely to go to zero, but often they incorporate other risks. Often, investors buy them by putting down 10% or less of a full futures contract's value to hold a position. This is similar to using a down payment to buy a house. If you use leverage, both your gains and losses are magnified.
Success with futures involves a degree of skill, market knowledge and good timing. You need to be able to monitor your positions closely, and apply appropriate risk-controls. If you don't favor the do-it-yourself approach, work with a professional broker who can act as an advisor.
You can also access commodity futures though a managed account, which is even more hands-off. Managed accounts are akin to mutual funds; you pick the commodity fund or manager and he or she makes the trading decisions.
Taxes: ETFs are typically taxed like stocks, based on your holding period. That's fine if you are a buy-and-hold investor. If you're a more active trader, short-term capital gains can take a big hit out of your returns.
In the U.S., futures are lumped together and reported on a single Form 1099 at year-end. Profits, if any, are taxed regardless of the holding period at a 60/40 rate--60% at the favorable long-term capital gains rate and 40% at the short-term capital gains rate.
Gold coins or bullion can be taxed as "collectibles" subject to the 28% tax rate. ETFs backed by gold or silver can also be subject to this collectible rate. Higher rates and/or penalties may be applied if investments deemed "collectibles" are included in an independent retirement account or other self-directed retirement account. Consult with an accountant when making your investment choice.
Mark Sachs is president of Lind-Waldock, a Chicago-based futures brokerage division of MF Global.

CFTC's New Regulations - The Law Of Unintended Consequences

from WSJ:

By BRIAN BASKIN

U.S. regulators have begun targeting the big-time speculators suspected of artificially inflating prices for oil, natural gas and gold. Turns out some of the big guys happen to be small fry.

Exchange-traded funds, which have become popular as one of the few avenues for small investors to gain direct exposure to commodity futures, are a top target in the Commodity Futures Trading Commission's drive to rein in speculation in oil markets. The CFTC's moves reverse a trend in market innovation that allowed almost anyone to bet on the direction of energy prices along with the likes of Goldman Sachs Group Inc.

And bet they did. Commodity ETFs came into existence in 2003 just as the boom in commodities prices was getting under way. They have ballooned to hold $59.3 billion in assets as of July, according to the National Stock Exchange.

Since the beginning of the year, $22.1 billion has flowed into these funds compared with inflows of $7.3 billion during the same period in 2008. Almost half of the new money that has come in this year has been directed at the largest commodity ETF, which buys gold, amid worries about inflation.

The funds pool money from investors to make one-way bets, usually on rising prices. Some say this causes runaway buying that ignores bearish signs that more knowledgeable investors and commercial hedgers usually heed. The CFTC has said its priority is to protect end consumers of commodities, who would benefit from lower prices that regulators and lawmakers say would result from limits on speculation.

Cutting out individual investors isn't the goal, said Bart Chilton, a CFTC commissioner, in an email. "The Commission has never said 'You aren't tall enough to ride,' " Mr. Chilton said. "I don't want to limit liquidity, but above all else, I want to ensure that prices for consumers are fair and that there is no manipulation -- intentional or otherwise."

Yet the coming regulatory changes are already reshaping this popular corner of the investing world for small investors.

Limiting the size of ETFs will result in higher costs for investors, ranging from individuals to banks and hedge funds with multimillion-dollar positions, because legal and operational costs have to be spread out over a fewer number of shares. It also would render the instruments less desirable, because prices of the shares of closed funds tend to deviate from price moves in the underlying commodity.

Already, U.S. Natural Gas Fund, or UNG, is trading at a 16% premium to gas futures because investors are willing to pay extra for the ability to expose their portfolios to the commodity. The PowerShares DB Oil Fund, which tracks crude futures with no share limit, traded 0.3% above its benchmark commodity Thursday.

This past week, UNG confirmed it wouldn't issue more new shares and said it owns about a fifth of certain benchmark gas contracts, potentially higher than the new limits will allow. Deutsche Bank AG's PowerShares DB Crude Oil Double Long ETN, or exchange-traded note, an ETF-like security similar to a bond, followed suit on Tuesday.

The CFTC said Wednesday that it withdrew exemptions it had granted two Deutsche Bank commodity ETFs years ago on speculative limits on corn and wheat contracts. On Friday, Barclays PLC said it would temporarily suspend any new share issues for its natural-gas ETN.

"What you're really saying is the only people who should be allowed to trade crude oil are oil companies and Morgan Stanley," John Hyland, chief investment officer for the company that manages UNG and the largest oil ETF, told CFTC commissioners in a hearing earlier this month.

He defended his funds as existing "to serve people who otherwise would find it difficult or undesirable to themselves buy futures."

Goldman Sachs and Morgan Stanley are two of the banks seen as most active in commodities trading. They also are likely to feel the impact from the new rules.

Mr. Hyland claims between 500,000 and 600,000 investors in his U.S. Oil Fund and UNG, both of which have come under scrutiny due their sheer size.

Vernon Reaser is one of those investors and says he is frustrated that regulators' actions are essentially discouraging him from accessing commodities markets. "I'm American and am all for stability," said the 43-year-old small-business owner in Houston. While small investors tend to shy away from futures because of high costs and margin requirements, without ETFs, "there's nothing left but futures," Mr. Reaser said.

Smaller funds could spring up to take in investors prevented from joining funds that have run afoul of federal limits, but at a price.

"If they give up on scale and have to drive their expense ratios up ... that just makes it a higher bar for the fund to jump to generate positive returns," said Mark Willoughby, a financial adviser with Modera Wealth Management in Old Tappan, N.J.

Mr. Willoughby recommends that most clients invest 4% to 7% of their holdings in commodities, but said his firm is debating the best ways to do so in light of recent developments.

Investors shut out of ETFs would still have a few ways to track commodity prices, such as a major oil company like Exxon Mobil Corp. Shares of such companies usually, but not always, move with energy prices.

Influence of Leveraged ETFs

from the Daily Options Report blog:

Now I know many prefer the notion that a cabal of a few Big Evil Hedge Funds control the close each day. But perhaps it's something even more sinister, Big Evil Leveraged ETF's? Or rather, the rebalancing of swaps thereof. This, from the Journal (hat tip Don Fishback and Abnormal Returns).

At 3 p.m., do you get queasy just thinking about the toll that the final hour of trading might take on your portfolio?

New research suggests that on days when the indexes make big moves, leveraged exchange-traded funds could trigger a trading cascade, turning the market close into a buying or selling frenzy.

........The excessive trading set off by releveraging is perfectly legal -- but upsetting to many people. "The market doesn't seem like a fair, level playing field," says Andrew Brooks, head of U.S. equity trading at T. Rowe Price in Baltimore.

Now a respected analyst -- Ananth Madhavan, head of trading research at Barclays PLC's Barclays Global Investors -- has released a report arguing that the potential ripple effects of releveraging have been underestimated.

Leveraged ETFs usually generate a multiple of the market's daily return by using something called a "total-return swap." Imagine a fund with $100 million in net assets and 200% leverage, meaning that it seeks to deliver twice the market's daily return. That requires the fund to maintain $200 million in swap exposure.

In a long swap, a counterparty like a bank or brokerage firm agrees to pay the fund $2 for every $1 rise in the closing value of a market index that day. On the other hand, if the market falls, the fund must pay the counterparty 2-for-1.

Now let's say the fund's net assets grow by $10 million during the day, to $110 million. The fund must raise its swap exposure from $200 million to $220 million to honor its 2-for-1 investment objective. That is $20 million in extra buy orders, all coming into the market after 3:30 p.m., typically in the final 10 minutes.

An inverse fund also must buy on a day when the market is up; since the value of its hedge has gone down, the fund must increase its exposure to keep its leverage ratio constant. Thus, all these ETFs buy in lockstep in the last few minutes of an up day for their index -- and sell in a swarm at the end of a down day.

I had heard this was a factor in why moves often snowball late in a day. But what I hadn't heard, but should have just known, was something like this.

Further amplifying the ETFs' actions: Every day, trading desks at big banks and brokerage firms blast out customized spreadsheets to favored clients. These tools, linked to live data feeds, predict whether the leveraged ETFs will be buying or selling as 4 p.m. approaches. That enables hedge funds and other big investors to trade ahead of the ETFs.

So while it's "comforting" to know these funds aren't causing the melt downs or melt ups, good to know they're still using a stacked deck to profiteer off it.

As always with these sort of shenanigans, you'll go broke waiting for the SEC to reign it in. The best tack is to know it's part of the backdrop, and trade accordingly. If it walks like a trend day and talks like a trend day, it's probably a trend day. Which means you likely get a low and last, or high and last, sort of close. And in a world of popular Leveraged ETF's, and hedge funds getting The Look, it's probable that move will get exascerbated. So it pays to just trade accordingly.

How ETF's Can Provide Valuable Information

from Dr. Brett-
A very nice set of ETF resources can be found on the Morningstar site, which tracks the returns of ETFs over 1 month, 3 month, 1 year, 3 year, and year-to-date time frames and ranks the ETFs by trading volume. A particularly unique feature identifies ETFs relative to their "fair value", so that investors can identify undervalued opportunities. A screener also helps traders identify ETFs by their investment style, returns, and expense ratios.

When we look at ETF performance and volume, we can gain some insight into hot market themes. Not surprisingly, ETF daily volume is dominated by the SPY and QQQQ instruments for the S&P 500 Index and NASDAQ 100 Index, respectively. After that, it gets interesting. The third most popular ETF as of Thursday's trade was the S&P 500 Index financial stock sector ETF, XLF. It is down over 11% over the past month, compared to SPY, which is only down 2.58% over that same period. The high volume decline suggests widespread pessimism about this sector, despite Fed (and sovereign wealth fund) attempts at relief.

Fourth and sixth in volume are the UltraShort vehicles for the QQQQ (QID) and SPY (SDS). These enable traders to take double-size short positions on the indexes, and thus are instruments favored by very bearish participants. Since the start of 2007, 20-day volume in QID, for example, has expanded over 10 times. Once again this speaks to the pessimism of market participants--and their desire for leverage, a theme I'll be touching upon in my next post.

Significantly, we have ETFs representing market indexes from Japan (EWJ), Emerging Markets (EEM), Brazil (EWZ), EAFE (EFA), and Taiwan (EWT), and Hong Kong (EWH) in the top 20 volume list--a strong indication of the degree to which investors and traders are taking a global perspective on markets and diversifying beyond the U.S. It is interesting to see the Brazil ETF at #9 in volume, given that it is up over 9% in the past month--a clear outperformer relative to U.S., Asian, and European bourses.

Finally, also within the top 20 ETFs for volume are instruments for S&P 500 energy stocks (XLE), S&P 500 materials stocks (XLB), and gold (GLD). This is a clear reflection of the flow of money into commodities and commodity-related issues. All three are up on a one-month basis, a notable contrast to the broad indexes, which are all lower over that period.

The above, of course, is a static view of volume and performance. It is the flow of funds in and out of ETFs that help us identify sectors and themes gaining favor. By tracking these statistics over time, we can follow in the footsteps of institutional investors and ride important market trends.

RELEVANT POST:

Tracking the Stock Market's Largest Traders

Day Trading ETFs

Over the next few days, I will be writing about day trading ETFs (and ETNs) in my other blog. I will also indicate which ETFs I day trade. There are only a handful with sufficient liquidity to do so. Did you know you can day trade crude oil through ETFs without any leverage?

Commodity Trader's Delight

I have posted today some information regarding some new commodity ETNs that are unique, for traders who are interested. Some of these ETNs track the soft commodities. I have been eagerly awaiting these ETNs for a very long time. Others track some industrial metals that I have never traded before, and I am unaware of futures for some of them.

There are also some new, unique currency ETNs as well. There is a link to my other blog and these posts at the right side of this page.

New Commodity ETN

I don't mention ETFs/ETNs on this blog very often, but a rather unique new commodity ETN has just begun trading. The symbol is LSC. It's uniqueness lies in that it takes both long and short positions in commodity futures. Read more about it on my ETF blog linked at the right side of this page.

Crude Prices Firm, But Gold Plunges

Today, several commodities are plunging in price, but particularly gold. Yesterday, gold reached a new all-time high price of $995.30/oz on the April. Gold fell nearly $30/oz. on Tuesday, after setting another all-time high price. This is a sign that bullish momentum is burning itself out.

This also appears to signal an end to the strong commodity prices surge since the first of this year. However, energy prices appear to be holding fairly firm. They are the only commodities that I am maintaining my positions on the daily charts. This seems a little surprising given that the US Dollar continues to explore lower price levels.

Deutsche Bank -- New Gold ETNs

This may spell perfect timing for Deutsche Bank. They just rolled out three new ETNs last week. Two of them are designed to short gold (one short, the other ultra short), and the third one is designed to benefit from being long (ultra long) in gold. Even the long ETN is somewhat unique and offers significant advantages to existing gold ETFs. I won't repeat here what I wrote about in my other blog. Here is the write-up on my ETF blog:

3 New, Unique Gold ETNs

Commodities ETFs

I have posted charts for 7 different all-commodity ETFs on my other blog. You can view them here:

Commodity ETFs Continue to Perform

Eventually, I plan to write an article pointing out the various differences between the all-commodity ETFs and review each one. For today, the charts will suffice.

Stagnant Stocks

The three blue boxes on these three S&P ETFs indicate that stock prices are in a trading range too tight to trade on a daily basis. The left-hand chart is the ultra short ETF. The middle one is the long ETF, and the one furthest to the right is the ultra long one. It matters not whether a trader is long or short -- the market is still stagnant. All three of them show that the Bollinger Squeeze indicator has contracted to the point that it is fruitless to try to trade on the daily charts. I won't trade any of them again until prices close outside the Bollinger Bands.

New Blog

I have started another blog. I will be posting to that site ETF charts that are showing signs of good trades. Each evening after the markets close, I will review many charts for various ETFs. I will post those charts to my new blog. That blog will be a lower priority for me than this one, however. The website is:

ETFCharts

Agricultural commodities ETFs for my IRA and stock portfolio

In am also long the following two ETFs (Exchange Traded Funds) in my IRA account: MOO and DBA. I am also watching JJA & JJG, but want to see a longer history before buying.

One important factor to consider in selecting an agriculture ETF is whether the ETF tracks the commodities themselves or businesses that grow them. I have noticed that ETFs that track the commodities tend to follow the underlying commodity trend better. The business-based ones tend to show greater sympathy to the stock markets and related indexes. However, the commodities ETFs that track the futures have different tax consequences, especially due to the contango phenomenon in futures. I always do plenty of research into these considerations before deciding which ones to buy.

NEWS:
Also have you heard about Jim Roger's new agriculture ETF (symbol: RJA)? RJA is a much broader-based agriculture ETF, but who better to manage an ETF based upon commodity futures than the master commodities uber-bull, Jim Rogers? His ETF is really taking off and growing very rapidly. I believe his ETFs will be some of the best-performing, without doubt. In fact, his all-commodities ETF (symbol:RJI) is significantly outperforming any other broad-based commodity ETF this year! Jim knows his commodities better than anyone! RJI is the broadest-based commodity ETF of them all, and the results are astounding.

Foreign vs. domestic stock ETFs

TIP: To view these charts in better detail, you may want to open them in another window. The above charts were saved in a single jpg file.

Note that in the above three charts, representing some of the most liquid and commonly-traded International stock ETF's, the chart patterns are nearly identical. If I didn't label them on my charts, I could hardly tell the difference. These charts are of very diverse areas of the world: Emerging markets, Europe, Australasia, China. If I posted the U.S. stock ETF charts (SPY, DIA, QQQ, UWM, etc.), they would appear nearly identical.

The point of this post is simply that trading a multiplicity of stock ETFs from around the world is really quite useless, because all appear similar and move nearly in lockstep with each other. Stocks around the world tend to trade in very mirror-like patterns, with relatively small differences. I have noticed this pattern perpetuate itself time and again, and I finally realized that trading stocks, whether in Japan, Germany, Hong Kong, or New York, is still still trading stocks.

I suggest trading the largest and most liquid stock index ETFs, so you can enter and exit positions with good fills, tight spreads, and minimal slippage. Whether those ETFs are U.S., European, or Asian ones is largely irrelevant. However, U.S. financial markets are among -- if not THE -- most liquid in the world, so I prefer to use them. If I were living in another part of the world, I might trade using their indexes. However, this would only be because of the time zone and the need to trade at an hour when those markets have the greatest liquidity.

One caveat: I trade ONLY ETF's -- no individual stocks -- and they are all based upon indexes for those parts of the world.