The WSJ has an article today looking at the ending of highly correlated asset classes. It seems that Equities are no longer correlated to the US Dollar and Gold as closely as they have been over the past 2 years. If history holds, this is positive for both the economy and markets longer term. It suggests a return to normalcy in investing.

Consider: Way back in the fall of 2008, just as the collapse in banks was picking up speed, the markets gave a fascinating warning sign: Many different asset classes that were normally non-correlated — equities, dollars, gold, fixed income, commodities, convertible bonds, real estate — suddenly became extremely correlated. This is typically a very strong warning sign.

Why? These assets classes normally trade on primarily differing inputs. They are the at core of a diversified asset allocation model specifically because they all trade so differently.

When all of these different asset classes suddenly start moving in lockstep, it is because the same too factors were driving them: Liquidity and Fear.

In the past, this high correlation occurred prior to major dislocations. (I have a study I need to dig up that shows exactly when and how this happens).

Here’s the WSJ:

“After a long stretch in which macroeconomic hopes and fears dictated the rise and fall of stocks, bonds and commodities—known in the market as the risk-on, risk-off trade—there are tentative signs that more-traditional concerns are reasserting their power.

In recent weeks, for example, moves in stocks and the U.S. dollar have had little connection—a breakdown of the trend during much of 2010, when they were virtual mirror images of each other. Stocks were considered risky and would rise when investors were feeling confident, while the dollar was a haven, benefiting when investors were worried.

Commodities, too, have broken away from rising and falling with risk perceptions. Now more old-fashioned concerns, like the weather, are having an impact. Corn, soybean and wheat prices jumped this month after supply estimates were cut due to dry weather in South America and floods in Australia.”

I am not sure I would agree with the title — it is not that markets are rediscovering the fundamentals, it is more that the sentiment trade is fading, and fund managers seem to be slowly getting over the trauma . . .


Markets Rediscover the Fundamentals
WSJ, January 24, 2011

Category: Commodities, Fixed Income/Interest Rates, Gold & Precious Metals, Markets, Technical Analysis

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

14 Responses to “There Goes the Neighborhood Correlation !”

  1. Luca says:

    More Hiring Expected as Gloom Starts to Lift

    U.S. companies optimistic about the economy plan to hire more workers in coming months, a quarterly survey released Monday found, another signal that the jobs market is turning up.

    The fourth-quarter poll of 84 companies by the National Association for Business Economics found 42% expected to increase jobs in the next six months. That is up from 29% in the first quarter of 2010. Only 7% of companies in the latest survey predict they will shed jobs in the coming six months, down from 23% at the start of last year.

    “It looks like the opening melody of a true recovery in the labor market,” said Shawn DuBravac, economist at the Consumer Electronics Association, a trade group, and chairman of the NABE committee that conducts the survey.

    The U.S. economy has been growing for a year and a half but companies have been slow to ramp up hiring. That may change soon as the economy is widely expected to pick up steam. To meet higher demand, many businesses have relied mainly on existing workers to increase output. But there is a limit to how much they can boost productivity.

    “The economy is potentially at a turning point in job creation,” said Randall Kroszner, a professor at the University of Chicago Booth School of Business and a former Fed governor.

  2. foosion says:

    The cliche version: In a crisis, all correlations move to 1.0.

    Your post leads to – if correlation is 1, you’re in a crisis and if correlation is decreasing from 1, the crisis is over.

  3. mathman says:

    better buckle up, just in case:

  4. rip says:

    IMHO, as long as Ben is throwing money around there are no past histories to draw correlations from.

    When and if the excess liquidity dries up watch what happens to commodities. There’s the 2011 action. Stocks seem to be running on animus which sh0uld have everyone on the edge of their seat. Get a firm grip on that rip cord.

  5. Petey Wheatstraw says:

    “Commodities, too, have broken away from rising and falling with risk perceptions.”


    “— it is not that markets are rediscovering the fundamentals . . .”

    Perception is a funny thing — while the gorilla sleeps, he’s easy to ignore, and the party starts again (of course, every now and then, when one of the revelers catches a glimpse of him snoozing in the corner, they sense a momentary sinking feeling, only to have it sublimated by the Next Big Thing at the party and irrationally exuberant reassurances from their fellows that the gorilla is dead).

    When the gorilla wakes up, he will be refreshed, hungry, enraged at all of the noise, unfettered by any sense of right or wrong, and ready to thrash some ass. There will be no escape.

    In this case, the gorilla is unsettled bad debt, historically unprecedented numbers of perpetually unemployed, a under-compensated workforce (along with continuing wage deflation), ZIRP, a huge inventory of moldering, bank-owned homes, toxic securities based on those moldering homes, structural reliance on borrowing from foreign nations to cover our operating expenses, tempting invitations for the private sector to take on new debt (even for the unqualified), instantly bankrupt recent college graduates, and our bankrupting military/foreign policy.

    The party is only in the markets (exactly where the Fed said it would be).

    I’m staying in the basement.

  6. MayorQuimby says:

    The only thing that matters is real-world cost of living inflation vs. wage growth. Gold is 100% irrelevant and equities are largely irrelevant. Most people live paycheck to paycheck and all of those people support the majority of our economy (or a huge chunk at least).

    All these ‘investor analyses’ are useless. You guys are lucky DJIA isn’t at 2,500 which is probably where it belongs (and may still be headed)!

  7. [...] The end of the risk-on, risk-off trade?  Looks like it.  (TBP) [...]

  8. constantnormal says:

    I am always suspicious when someone uses a chart covering only the past 2 years to illustrate “the fundamentals”.

    I eagerly await enlightenment by the study Barry mentions that shows how correlation leads to major dislocations, and how major dislocations do not occur when there is poor correlation — unless you have both, it isn’t a relationship worth mentioning.

  9. NoKidding says:

    Petey Wheatstraw, I couldn’t agree more, but I was also riding the SPXU train last September at the worst possible moment. The carrying cost is so high its scary to try it again.

    Mayor Quimby, equities irrelevant to whom? Then why are we talking about them?

    constantnormal, are you trying to say that correllation is not causation?!

  10. bulfinch says:

    Petey Wheatstraw: Basement is not safe; even a groggy gorilla knows how to make its way down a stairwell.

    MayorQuimby: there are those that would disagree with you, suggesting instead that the paycheck-to-paycheck crowd are effectively helots, enthrall to the financial classes and their bedfellows.

  11. MayorQuimby says:

    Bul- They run the machines. ’nuff said.

  12. Bruman says:

    Fear is what drives correlations to 1. Greed can do it too, but it is not as powerful, because people run to the same place when there is fear (basically US Treasurys), but they can run to different places when there is greed. At very high levels of greed, then people do chase returns, so there is some effect, but it is not as strong as fear.

    So the cooling of correlations seems to suggest that fear is subsiding. As a macro guy, this is not necessarily a bad thing, because it allows us to use separate analyses by asset classes again, which helps us create more diversified macro bets.

    Another interesting analysis would be to take a look at the rolling correlations of stocks within equity sectors. Maybe Kevin would want to see if the distribution of correlations between individual stocks and their sector indices (or the market index) has changed much. Basically a market-breadth approach to the correlation analysis.

  13. Investradamus says:

    “50% Please”

    “I’ve noted in the nightly updates that gold is now deep in the timing band for a daily cycle low. My best guess is gold should tag the 38% Fibonacci retracement before bouncing out of that short term bottom.

    However the stock market still hasn’t moved down into it’s yearly cycle low yet.Both gold and stocks are now due for a major yearly cycle low. This is a much higher degree correction than a daily or intermediate cycle pullback. So the corrective moves in both gold and stocks should be very severe. I would be very surprised if both don’t correct at least to the 50% retracement.

    Notice on the gold chart how the rally out of the yearly cycle low in the dollar halted (temporarily) the C-wave rally in gold.

    The dollar is now moving into the timing band for another short term bottom. I expect the rally out of that coming bottom to drive the final leg down in gold and to power the move down into the yearly cycle low for stocks.

    While I fully expect gold to bounce off the 38% retracement I doubt that will be the end of the correction. A yearly cycle low usually has to do more damage than that, especially if it’s coupled with the massive selling pressure of stocks also moving down into a yearly cycle low.

    Those that want to speculate could enter precious metal positions at around $1325, but be prepared to get stopped out if gold dips back below that point next week on it’s way down to $1290.

    Personally I’m going to wait until I think the stock market has bottomed before I’m ready to jump back into heavy positions. ”

    Gold bugs have been warned. Though, IMO, if gold hits $1290, you buy the ****ing dip!

  14. Dow says:

    I can’t see what the market has to do with those of us who don’t play on Wall Street. I used to see a connection – but now it just looks like one massively over inflated fantasy disconnected from the uber real life world of salary, groceries, housing, and transportation. Which makes me think the market is facing its own bubble a la housing circa 2006.