Frequent price reversals have made for a difficult trading environment for commodity trading advisors (CTAs) in 2009 but Troy Buckner, managing principal of NuWave Investment Management, believes a breakout could be just around the corner.

CTAs were the top performers in the hedge fund industry in 2008. The positive performance of many CTAs contrasted sharply with the 38.5% decline in the S&P 500 stock index and the travails of other hedge fund managers.

The average CTA returned over 14% in 2008, according to the Barclay CTA Index.

This year has been a different story. A prolonged period of choppy and highly corrective market moves has made it difficult for CTAs to consistently make money in 2009, even as others have profited from the rally in the equity and commodities markets.

The Barclay CTA Index was down -0.98% at the end of August.

"The markets have been very difficult for systematic directional traders. We have seen extremely choppy, corrective activity throughout 2009 across the more than 30 markets we trade. There have been few dominant trend cycles," said Buckner.

Buckner said recent price action indicates market participants are acting on divergent concepts.

Equities have rallied to new highs this year even as bond yields have retreated after an initial recovery. "Something is wrong with that picture. It implies that market participants have completely different ideas about the risks associated with the economic recovery. That dichotomy should provide opportunities for divergence orientated strategies employed by CTAs," said Buckner.

Commodity prices have been buoyant for much of 2009 as traders bet that an economic recovery and stock market gains will lead to stronger demand for raw materials. Expectations of higher inflation in the coming months have also bolstered the case for commodities.

However, Buckner believes the picture in the commodity markets is more complex than it first appears. He notes crude oil prices have moved in lock-step with the S&P 500 and are up around 50% since the stock market rally began in early March.

At the same time natural gas futures have been going in the opposite direction, with prices dropping an additional 50% to a seven year low at the beginning of September.

"The trends in crude oil and natural gas prices do not reflect the same underlying fundamentals. How can they be moving in opposite directions given that we are oversupplied in both?" asked Buckner.

Recent price activity supports the argument that markets are currently being driven by sentiment and speculation, said Buckner. He sees some parallels with last year when the spectre of bank failures caused panic selling and a departure from the fundamentals.

"The tail event in 2008 has been followed by a similar tail event this year. In both scenarios the markets have been characterised by high levels of correlation between asset classes, with prices moving out of sync with the fundamentals. The market collapse and the subsequent recovery have happened at an accelerated pace," said Buckner.

Distorted market
The distortion in the markets could be further exacerbated by regulatory intervention. The Commodity Futures Trading Commission (CFTC) is expected to take action to enforce position limits on long-only index funds in a bid to prevent commodity prices being driven higher by speculation.

The ripples are already being felt in the markets. Deutsche Bank said last week it would close its PowerShares DB Crude Oil Double Long Exchange Traded Notes and redeem investors due to regulatory position limits.

The CFTC is believed to have revoked other no action letters issued to index funds. "There will be near-term distortions if this continues. These funds have billions of dollars invested in the commodities markets," said Buckner.

The equity markets could also be impacted if the US Securities and Exchange Commission (SEC) pushes ahead with plans to reinstate the uptick rule and imposes other restrictions on short selling.

The regulatory uncertainty and the push and pull between competing views on the future means there have been no dominant trend cycles for CTAs to exploit.

However, it is only a matter of time before there is a breakout, said Buckner. "The period of correction has been extended and that usually leads to opportunity for CTAs," he said.

"The current price action indicates that market participants remain unsure of what the true fundamentals are. This causes markets to search out new equilibrium price levels, which in turn results in the emergence of dominant price trends."

At this stage it is difficult to predict which of the competing views on the future will ultimately prove correct. "It could be the equity buyers or it could be the fixed income traders. Once those debates are settled it will become easier for CTAs to trade," noted Buckner.

He said some opportunities were already beginning to manifest. CTAs saw gains on average in August after two months of losses, according to Barclay Hedge.

Buckner believes 2009 could yet end on a strong note for CTAs. "It is too soon to write us off," he said. "In 2008 the majority of CTAs were either flat or down into the middle of the year, only to finish with their best returns ever."