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Looking at data for the 31 commodities, the authors found that an above-average basis did indeed coincide with low inventories, and vice versa. "The empirical evidence is consistent with the prediction of the Theory of Storage, and suggests that the basis is a useful indicator of the level of a commodity's inventory," the authors conclude.
Similarly, they found that past returns on futures contracts are a good indicator of present inventory levels. High returns, for example, coincide with reduction in supply, which equates to reduced inventories. Traders, therefore, can use prices to determine when inventories have fallen to levels likely to make futures contracts especially profitable, Gorton and his colleagues note. The authors created two portfolios to test this. For the first, they ranked commodities according to their futures basis. In this case, that was defined as the difference between the price in the contracts maturing the soonest minus the price in the contracts maturing after that -- three months later, for example. The High Basis portfolio contained equal amounts of contracts for commodities in the top half of the rankings, and it was adjusted every month as the rankings changed. The authors found that from 1990 through 2006, this portfolio produced average annual returns of 14.67%, compared to about 9% for an index of futures contracts that did not take bases into account. For the second portfolio, they ranked commodities according to their futures contract returns for the prior 12 months. The 50% with the highest returns were put into the portfolio and adjusted every month as the rankings changed. For the 1990-2006 period, this Relative Strength portfolio would have returned 16.67% a year. While both portfolios were slightly more risky than the index, this was more than compensated for by the outsized returns. Finally, the authors looked at how their trading strategies would stack up against competition in the real world -- the CTAs, which operate investment pools similar to hedge funds. For this they used the High Basis and Relative Strength portfolios, assuming an investor would buy these contracts, or go long. In addition, they assumed the investor would short, or sell, contracts that were in the bottom half of the two rankings. That strategy would profit from the poor performance of the commodities with low basis and poor relative strength. The study also assumed the investor would pay annual fees of 2% of assets, similar to those paid by CTA investors. From 1990 through 2006, this approach would have returned an average of 10.88% a year, compared to 5.76% for a standard CTA performance index published by Barclay Trading Group. "If you constructed trading strategies based on these signals, you would do rather well," Gorton said. "You would do much better than CTAs."
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