Does Canada belong to the Emerging Markets?

Many of us Canadians like to think of our economy as a member of the advanced, post-industrial world, with the landscape dotted with brand-name companies such as Nortel Networks, Research In Motion, and Four Seasons Hotels. In the back of our minds, of course, we know we are also a resource-rich country. But still, it may come as a bit of an embarrassment to find out that, of all the sector index funds we can compare the MSCI Canada Index fund EWC to, it cointegrates only with the natural resource index fund IGE. Even the financial sector indices do not come close, despite the presence of numerous financial services companies in the Canada Index. As usual, in the chart below, I plotted the spread between 100 shares of IGE and 400 shares of EWC, and we can see for ourselves how this spread stubbornly sticks close to zero.






One may note that IGE also cointegrates with the Emerging Markets index fund EEM. (The chart below is the spread between 100 shares of IGE and 100 shares of EEM.)


This is not surprising. But does this imply the unsettling conclusion that the Canadian economy cointegrates with the emerging markets? No. I will not bore you with yet another chart: just be assured that cointegration is not a transitive relation.

Trading a platinum-gold seasonal spread

Quantitative traders can sometimes lose sight of the fact that many profitable trading strategies are extremely simple, requiring no math at all. Such is the case with a seasonal spread trade between platinum and gold that was profitable in all but one of the last 7 years. This is far more consistent than the seasonal spread trade that ruined Amaranth (see my earlier article).

The strategy is extremely simple: buy 2 July contracts of PL and short 1 June contract of GC around the end of February, and exit the positions around mid-April. (The gold futures contract specifies 100 ounces, while platinum is only 50, therefore we need to buy 2 contracts of PL vs. 1 contract of GC.) I first read about this strategy in an article by Jerry Toepke in the SFO Magazine in the beginning of 2006 and I decided not only to backtest it, but also paper trade this strategy in 2006 to see if it works its magic again. Both the backtest and the paper trade worked as advertised, despite being widely publicized by the magazine. I plot the P/L in this chart:


This spread earned an average of $6,600 every year since 1995. We earned $15,400 in the best year, while in the worst year we lose only $3,810. With a margin requirement of only $743 for trading this spread at NYMEX, the return per trade is not bad!

What is the fundamental reason this seasonal spread works? Amusingly, it has to do with the end of the Chinese New Year. According to Mr. Toepke, the demand for gold is driven by demand for jewelry. Asian countries such as India and China are the largest consumers of gold. A series of festivals and celebrations in these countries around year-end lasted till the end of the Chinese New Year in February, after which demand for delivery of gold is seasonally exhausted. Platinum, on the other hand, is primarily used in catalytic converters for automobiles, and the seasonality is much weaker. It is therefore handy as a hedge for gold prices.

Further reading: Jerry Toepke, “Give Seasonal Spreads Some Respect”, Stocks, Futures and Options Magazine, January 2006 issue.

Cointegration of OIH with spot oil price

Both my friend Yaser Anwar over at the Investment Ideas blog and my reader Jim urged me to test the oil services ETF OIH instead of XLE for cointegration with crude oil price. Their reasoning is that OIH is composed of oil drilling companies such as Schlumberger and Baker Huhges, as opposed to XLE, which is composed of oil-production companies like Exxon. The oil-drillers are more cyclical and react more to spot oil price rather than far futures contract prices. The hope is that OIH will tend to cointegrate better with spot oil price than XLE because of this. The fact that OIH has higher volatility as a result is not a concern to the arbitrageur (as opposed to the hedger), who profits from high volatility. In any case, its volatility should “cancel out” that of the spot oil price and result in a spread that may actually be less volatile. I follow their advice and carry out the analysis of CL vs. OIH.

The plot is of the dollar value of long 1 contract of Cl and short 497 shares of OIH. They do cointegrate with over 90% probability. (I also plotted the 1 standard deviation lines of the spread to facilitate those who want to look for approximate entry points.) The cointegration probability is not measurably better than that between CL and XLE. However, the current spread (as of the close of Nov 20) is undervalued by only $9,617 (or 1.48 standard deviation), as opposed to $10,508 (or 1.74 standard deviation) for the CL-XLE spread. (I determined the standard deviation of the CL-XLE spread to be about $6,040). So in recent months, one can indeed say that OIH is trading more in line with spot oil price than XLE. But as an arbitrageur who thinks the larger the spread, the bigger the profit opportunity, this is not an endorsement for buying the CL-OIH spread instead. Rather, I would consider adding this spread as a means of diversification.

Thanks, Yaser and Jim, for this suggestion!